Has the smart-beta train run out of steam?

Factor ETF launches could be losing ground as investor appetite for other products grows

Has the smart-beta train run out of steam?

Just a few years ago, new smart-beta strategies were appearing on fund managers’ shelves at a remarkable pace, with many touting their potential as a middle ground between active management and passive investing. Now, the flood has slowed to a trickle – and it’s not just because of market saturation.

Citing figures from FactSet, Tom Eckett, deputy editor at ETF Stream, said that the smart-beta space has seen healthy demand and asset growth over the years, with AUM growing from US$616 billion in 2016 to approximately US$818 billion today. But over the past two years, he said launches have sputtered, with Bloomberg data showing just nine smart-beta product launches this year up to August 25, compared to 203 launches between 2015 and 2017.

“One obvious reason for the drop in launches is ETF issuers are turning their attention to other parts of the market where they see rapidly growing investor demand,” Eckett wrote in a recent piece. One notable growth segment is ESG investing, as reflected by the 46 ESG ETF launches that have occurred in Europe this year as of June 30 to surpass the previous 2018 peak by 11.

In a recent report, analysts from Citi forecast that smart beta would be replaced by ESG and thematic funds. Calling smart beta “passe,” the analysts pointed to the emergence and adoption of both ESG and thematic solutions, with ESG being more effective in replacing traditional core indices while longer-term alpha seekers become increasingly attracted to thematic differentiation.

Aside from that turning of trends, Eckett said the smart-beta market is maturing. One reason is structural: with just five or six academically backed factors, there is a natural limit on the number of products that can be launched. He cited Athanasios Psarofagis, ETF analyst at Bloomberg Intelligence, who said the universe has been largely saturated following the cascade of launches in 2016 and 2017.

“In 2016, there was a massive push in low volatility strategies but this has shifted to ESG and thematics this year,” Psarofagis said. “This is pretty normal.”

Smart beta could be coming to an inflection point as the slowdown paves the way for what Steven Goldin, managing partner and CIO at Parala Capital, called a “digestion” in the space. While different strategies may fit under the umbrella of “small cap,” for example, Goldin said the market will start “vetting” strategies as certain products prove to be more effective at doing what they were supposed to do than others.

Recent academic research also points to another possible structural shortfall. In a study titled The Smart Beta Mirage, researchers found that smart beta ETFs tended to see a sharp performance drop after they are listed. Citing co-authors Yang Song at the Univeristy of Washington and Shyang Huang and Hong Xiang at the University of Hong Kong, Eckett said the study found that smart-beta indices had an average return of 2.77% per year before ETF listing, only to decline to -0.44% per year after listing.

“We find evidence of data mining in constructing smart beta indexes as the post-ETF-listing performance decline is much sharper for indexes that are more susceptible to data mining in backtests,” the authors said, warning that the stellar performance based on back tests used to entice investors could be just an artifact arising from an overreliance on data mining.


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